The Emerging Private Equity Economy
"One should hardly have to tell academicians that information is a valuable resource: knowledge is power." - G. Stigler "The Economics of Information"
The strength of the recent boom in private equity has many analysts concerned that a growing percentage of the United States' gross domestic product is moving "off the radar". Because private investors are under no obligation to share financial information in the way that society has grown accustomed, these analysts are concerned that the resulting information opacity increases the risks of unexpected economic shocks.
Private equity refers to investment in assets that are not available on for public trading. Virtually all small businesses are organized as private businesses, but in the rarefied environs of the nation's largest companies the preferred organization is the public corporation.
When private equity firms approach a public company with an offer to buy the company and take it private, they typically offer a substantial premium to the market value of the company. For example, when private equity firm KKR purchased First Data for over $25 billion, this represented a 26% premium over the prevailing market rate for the shares of the company.
Private equity firms are capable of purchasing any business, public or private, but many of the larger firms have concentrated on purchasing distressed companies that have recently undergone troubles. These so called turnaround jobs have been a significant source of acquisitions recently. Two private equity giants, Blackstone and Centerbridge, are engaged in a bidding frenzy for the troubled Chrysler arm of DaimlerChrysler. Chrysler lost over $1 billion last year, but DaimlerChrysler will receive in excess of $6 billion for the company.
While private equity investments carry their own risks, they also are uniquely suited to reward the greater economy. Private equity's ability to look beyond the day to day shifts in stock price and concentrate on building long term wealth could allow enhanced risk taking. When TXU was purchased by a consortium of private equity firms, the staid energy giant changed its culture. The firm shelved plans to build coal-powered plants and now is working on the largest nuclear facility in the United States. This change from safe investments to much more risky operations could only occur thanks to private equity.
The real concern with private equity, however, is the high debt load taken on by the acquired company to leverage the investment made by the principals. These so called leveraged buyouts result in companies with huge amounts of debt. And the risk of companies becoming unable to service that debt in an economic downturn is no small matter. The IMF has publicly warned regulators around the world to pay close attention to rising levels of private debt.
All of these concerns notwithstanding, private equity is clearly the way of the future. The reason is clear - enormous profits are possible. When Google purchased DoubleClick for $3.1 billion, it also allowed a private equity firm to get out of an investment it only paid $1.1 billion for, just a few years ago. These substantial profits will attract a growing part of the investment world.
The increasingly global economy is also becoming an increasingly private economy. New risks abound in this changing landscape, but the rewards for success will be substantial.
About the Author: Erasmus is a principled apostle of the new economic age. View the future at his blog Slouching Toward Serfdom.
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Print Article | Download PDF | 359 views | Apr 20 2007
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